Trading with Legendary Donchian Channel Indicator

In the golden times of technical analysis, one name stood above everyone’s: Richard Donchian. Also called the father of trend following, he built the now famous Donchian channel indicator mt4 traders use. Despite its reputation, the Donchian channel indicator is not only a trending tool.

Instead, it plays a vital role in showing volatility. Or, the volatility of a financial product.

Because it deals with volatility too, the Donchian channel falls into a select class of indicators. Tools like:

Average True Range

Chaikin’s Volatility

Volatility Quality Index, and so on, come to complete a volatility’s trader’s arsenal.

However, the Donchian channel indicator has multiple uses. It deals with trend following too.

For many, it looks like the Bollinger Bands indicator. Because the Bollinger Bands also has trend and volatility characteristics, traders’ confusion makes sense.

This article aims to bring the work of Richard Donchian to good use. Why is there a need for such a thing?

As he was mainly a commodity trader, his findings and concepts won’t work on today’s Forex market. Or, not all of them.

The idea is to bring to life what Forex traders can use. Moreover, to explain the Donchian channel indicator mt4 platform offers.

Among other topics, we’ll cover:

Richard Donchian’s technical analysis legacy

The best ways to use the Donchian channel metatrader 4 indicator

Money management rules laid down by Donchian

The idea is to take the best out of his work. And in doing that, to pay respects to one of the founders of technical analysis as we know it today.

DONCHIAN’S CONTRIBUTION TO TECHNICAL ANALYSIS

For someone who published his leading work in the middle 1900’s, Richard Donchian is pretty famous. Those were the golden days for technical traders.

An oscillator’s main use is to spot divergences. Namely, divergences between the price and the oscillator.

The chart uses the RSI to time exits, but any oscillator works. Just keep in mind that price typically tends to make fake moves. Not the oscillator.

The two entries followed the system described earlier. From left to right:

Wait for a pullback below the middle band.

Go long at the next breakout

Stop loss at the lower band

Stay for 1:3 rr

BUT, there’s a catch. The RSI forms a considerable divergence. A bearish one.

And, the trade didn’t reach the take profit. What to do? EXIT, of course. Take the money and run away!

The same happens with the following short trade. Only this time, the RSI forms a bullish divergence.

Exiting earlier is a sign of recognizing a change. Reacting to it is healthy for a trading account.

DONCHIAN CHANNEL INDICATOR AS A VOLATILITY MEASURE

To use the Donchian channel indicator, mt4 traders must upload it to the platform. It doesn’t come with the default settings.

A simple Internet search tells you this is a trend indicator. If you consider Donchian as the father of trend following, then yes, that’s true.

However, the real use of it is to measure volatility. Or, to spot irregular volatility before a breakout.

Next, to trade that breakout for a profit. Finally, rinse and repeat the process.

Luckily, the concept works on the currency market too. And, with so many currency pairs available, volatility gives plenty of opportunities to trade. Even if the daily chart requires patience.

VOLATILITY BREAKOUTS RULES WITH THE DONCHIAN INDICATOR

As always, setting rules only help. And this time, it requires a bit of historical research.

The thing to look for is periods of time when the Donchian upper and lower lines narrowed the most. Or, not the most, but the narrow to be smaller than normal.

That’s happening before a major market break. That’s the true use of volatility in Forex trading.

On the EURAUD chart above you see the daily price action over the last fourteen months. The original volatility measure uses a square to depict the corridor between the upper and lower bands.

Next, copy the square and project it every time you see the bands narrowing. If they narrow more than the square shows, that’s a signal to trade the next break.

It shows the market is about to break, as volatility will pick up after such a narrowing. On the other hand, if the contraction is more significant than the measured move, just ignore the next breakout.

Using the logic described above, out of the three situations, only two represent a real signal.

ENTRY, EXIT AND STOP LOSS WITH DONCHIAN VOLATILITY SYSTEM

Now that we know when to expect a real breakout using volatility, we need some rules. Or, trading rules.

First, we must set the entry. This is straightforward: in a bullish trend, buy the break above the upper band.

Second, set the stop loss at the previous swing lower. Having a stop loss is a mandatory condition for every trade.

Finally, set the take profit using a 1:2.5 or 1:3 risk reward ratio. Even better, use trailing stops to right the upcoming trend as long as possible.

From left to right, the first square tells us a breakout comes. It turned to be bullish and proved to be a great trade.

Following the above rules, the take profit gets hit fast. Using a trailing stop, the trade might still be in place.

The second square shows the bands missing the volatility signal. Hence, both the upper and lower breakouts should be ignored.

The third square is our measured move. Let’s skip it this time.

But the fourth is another great entry. Still on the long side, with quite a tight stop loss.